Market Failure: Where the free market mechanism fails to achieve economic efficiency, this can be displayed through either allocative inefficiency (failure to correctly distribute factor endowments) or productive efficiency, where a firm is failing to produce at the lowest point on it's average costs curve and not using the minimum amount of scarce resources neccesary.
Consumers need to be maximising there wellfare by making the "correct" and rational decisions. This will allow the free market to provide the best allocation of resources and hopefully achieve allocative efficiency. However, due to an incomplete/inaccurate supply of information to consumers, they are not always aware of the positive and negative consequences of consuming a certain product. Persausive advertising can lead to consuming goods that do not maximise there consumer welfare causing market failure. One key aspect of information failure is asymmetric information, in which both parties do not share the same level of knowledge. This can be both benefitial and harmful for the consumer but causes market failure in both cases. Information failure also occurs in the provision of demerit/merit goods. In merit goods, the consumer may not realise all of the social benefits associated with the good and in demerit goods they will be unaware of the social costs. See Merit/Demerit good section for more details.
Costs and Benefits
Costs and benefits can be split into two different sections, external and private. Private costs and benefits are those incurred by one of the two parties directly involved in the deal, the consumer and the firm. External on the other hand fall on the third parties, "they are not paid by, nor do they accrue to those responsible for the action". Both the private and external benefits grouped together are known as social benefits.
These occur when either the social costs are greater than the social benefits (negative externalities), or when the social benefits are greater than the social costs (positive externalities.
- Wastedumping, generally minimal cost to the firm that dumps the waste, but high costs for the third party like the local council.
- Chewing gum, essentially the same theory, costs nothing for a person to dispose of gum on the street but can be expensive to remove, i.e. costs the local council more money.
These cause allocative inefficeincy, the Negative externalites are not shown in a dmeand supply diagram, the supply curve should actually be shifted to the left in order as the price is currently to low and the qauntity supplied is currently to high.
It usually comes down to the government, or some governmental organisation to decide wether or not a good is a merit good as they have an abundance of information at their disposal. Since we assume that information failure will take place amongst consumers as to which goods they should be consuming (merit/demerit) the government decides. As an individual doesn't have all of the neccasary information concerning the positives and negatives, it commonly leads to merit goods being under consumed and…